Download Market Structure and the Behavior of Firms Market Structures

Market Structure and
the Behavior of Firms
Market Structures

Benchmark models


Perfect Competition
Monopoly
It’s registration time…how about economics?
Major








Econ 211 (Micro I)
Econ 212 (Macro I)
Econ 349 (Micro II)
Econ 375 (Macro II)
Math 123 (Stats)
Econ 420 (Regression)
Econ 421 (Empirical Research)
12 additional hours in Econ
Minor
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Econ 211
Econ 212
Math 123
9 additional hours in Econ
18 hours
33-34 hours
Fall 2008
Spring 2009
• Econ 325 (Gender Econ)
• Econ 350 (Environmental Econ)
• Econ 360 (Law & Econ)
• Econ 420 (Regression)
• Econ 301 (Money & Banking)
• Econ 340 (Sports Econ)
• Econ 349 (Micro II)
• Econ 414 (Int’l Econ)
Behavior of Firms

What is the objective of a business?

Assume firms maximize profit
 = TR – TC
TR = Total Revenue = Pq
TC = Total Economic Costs
Economic Cost = Explicit Cost + Implicit Cost
Suppose that a young chef opened his own restaurant. To do so, he quit his job,
which was paying $36,000 per year; cashed in a $6,000 certificate of deposit that
was yielding 5% (to purchase equipment); and took over a building owned by his wife
which had been rented out for $3,000 per month. His expenses for the first year
amounted to $60,000 for food, $40,000 for extra help, and $7,000 for utilities.
The chef is trying to figure out whether he would have been better off not being
in business last year. He knows how to calculate his revenues, but he needs help
with the cost side of the picture. What were the chef's total economic costs?
$107,000
$113,000
$149,000
$185,300
1.
2.
3.
4.
Explicit Costs
Implicit Costs
$60,000 (food)
$36,000 (foregone job)
$40,000 (extra help)
$7,000 (utilities)
$300 (foregone interest)
$36,000 (foregone rent)
$6,000 (equipment)
$113,000
$72,300
Total Economic Cost = $185,300
1
2
3
4
5
0%
107000
0%
0%
113000
149000
0%
185300
Technological Constraints

Production Function
_
q = output
L = labor
K = capital
F(·) represents technology
q = F(L, K)
Variable input
Fixed input
Lab Experiment 3: Widget Production
Other measures of productivity

Total Product
q = F(L, K)

Average Product
AP = q/L

Marginal Product
MP = Δq/ ΔL
Note: Diminishing Marginal Returns (DMR)
When there is at least one fixed input,
eventually a point is reached at which the
marginal product of an additional worker
begins to fall.
Productivity Graphs
DMR
Slope = MPL = ∆q/ ∆L
output
q/L
∆q
TP
∆L
AP
L1
L2
labor
labor
L1
L2
MP
Measuring Marginal Product


Batting Averages
GPAs
First Year
Second Year
GPA
Fall
Spring
Cumulative
4.0
2.0
3.0
3.0
3.5
3.125
Third Year
Fourth Year
When MP > AP then AP will rise
When MP < AP then AP will fall
Number of Workers
0
1
2
3
4
5
6
7
8
9
10
Total Donuts Produced Daily
0
12
26
44
64
86
110
122
125
127
128
Which worker at Decent Donuts has the highest marginal
product?
1
2
3
4
5
0%
0%
0%
nt
h
xt
h
fif
th
ve
se
e
e
Th
Th
e
fo
ur
th
0%
si
d)
Th
c)
e
b)
The fourth
The fifth
The sixth
The seventh
Th
a)
Short Run Costs
TC = FC + VC
Does not vary with output:
Rent
Utilities
Salaries
Property taxes
Insurance premiums
Varies with output:
Labor
Raw materials
Short Run Cost Curve Family
TC
$
VC
$
MC
ATC
AVC
FC
AFC
output
TC = FC + VC
output
ATC = AFC + AVC
MC =
ΔTC
Δq
Which of the following would be classified as a variable cost for
the local Texaco gasoline station?
interest payments to a local bank for a
loan.
the local property tax on the building
owned by the Texaco operator.
the premiums paid for liability insurance,
which are fixed at about $30,000 per
year.
the federal excise tax paid on each
gallon of Texaco gasoline sold.
a)
b)
c)
d)
0%
a)
1
2
3
4
5
0%
0%
b)
c)
0%
d)
Properties of the Cost Curves

“Ross Perot” Equation
$
MC
w
MC 
MPL
$
MC
ATC

Short Run Cost Curve Shifters




Change in price of labor
Change in price of capital
Change in amount of capital
Change in technology
output
AVC
q/L
AFC
output
MP
labor
Austyn's fixed cost is $3,600. Austyn’s employs 20 workers and
pays each worker $60. The average product of labor is 30, the
marginal product of the 20th worker is 12. What is the marginal
cost of the last unit produced by the last worker Austyn’s hired?
a)
b)
c)
d)
$0.20
$5
$240
$720
w
60
MC 
 5
MPL 12
0%
0.2
1
2
3
4
5
0%
0%
5
240
0%
720
Long Run Costs

What is the optimal size for a factory?
$
ATC1
ATC2
ATC4
ATC3
q2
LRAC
output
Long Run Average Cost Curve
$
ATC3
Specialization
LRAC
Coordination/Communication Problems
qMES
output
EOS: double the inputs, output more than doubles
 LRAC falls
DOS: double the inputs, output less than doubles
 LRAC rises
When all inputs increase by 40% and output
rises by 30%, the firm is experiencing:
Diminishing returns
Economies of scale
Diseconomies of scale
Constant returns to scale
TC
ATC =
q
1
2
3
4
5
nt
re
t
st
a
on
C
ur
ns
.
of
...
ie
s
no
m
..
e
of
ie
s
om
on
Ec
D
im
in
is
h
in
g
re
tu
rn
s
0% 0% 0% 0%
sc
al
d)
co
c)
is
e
b)
D
a)
Perfect Competition:
Price Taker Model

Characteristics of the Industry




Large number of small buyers/sellers
Homogeneous product
Free entry/exit
Perfect information
 firms are price takers
$
S
MR = ΔTR / Δq
$
P1
P = MR
D
Q1
Industry
Quantity
quantity
Firm
Maximizing Profit
 = TR – TC
 = P  q - [FC + VC]
$
MC
MR
$60 = P1
What output should firm produce?
 produce until MR = MC


If MR > MC  produce more
If MR < MC  produce less
q1 = 300
quantity
I want you
to maximize profit
What is TR = ?
What is TC = ?
In a perfectly competitive industry, the market price of the
product is $12. Firm A is producing the output at which average
total cost equals marginal cost, both of which are $10. To
maximize its profits, Firm A should:
expand output
reduce output
leave output unchanged
decrease its price
a)
b)
c)
d)
0% 0% 0% 0%
t
pu
t
ou
t
.
...
p.
t
o
its
pu
t
e
d
e
ou
uc
as
an
d
e
p
e
r
c
re
ex
av
de
le
1
2
3
4
5
pu
t
u
.
Profit and Loss Diagrams

Positive Profit:  > 0








= Pq – (ATC)q
= (P-ATC)q
= (60-50)300
= $3000
$
MC
ATC
$60 = P1
MR1
$50 = ATC
$35 = P2

Negative Profit



MR2
 = (35-50)250
 = -$3750
Zero Profit?
q2 = 250 q1 = 300
quantity
Juan’s Software Company is a perfect competitor. Juan has
total fixed costs of $25,000, average variable costs for 1,000
units of the product of $45, and marginal revenue of $75.
What is his total economic profit?
$5,000
$25,000
$45,000
It is impossible to determine
with the information given.
a)
b)
c)
d)
0%
a)
1
2
3
4
5
0%
0%
0%
b)
c)
d)
Sometimes it’s better to stay open
and lose a little bit…

Temporary Shut Down: q = 0



$
MC
 = Pq – (FC +VC)
 = 0 – (FC + 0)
 = - FC
ATC
AVC
$35 = ATC1
Fixed Cost = $30,000
$25 = P1
MR1
$20 = AVC1
q1 = 2000


Stay open if TR > VC
Shut down if TR < VC
Stay open:  = -$20,000
Shut down:  = -$30,000
quantity
A competitive firm is
maximizing profits by
producing 600 units of
output at the current
market price of $800 per
unit. The firm has AFC of
$150 and total costs of
$600,000 at this output
level.
Firm should shut down since TR < VC
TR =
$480,000
TC =
$600,000
 =
-$120,000
FC =
$ 90,000
VC =
$510,000
ATC =
$1,000
AFC =
$150
AVC =
$850
MR =
$800
MC =
$800
SD =
-$90,000
Shutdown recap
$
MC
Note:
The portion of the MC
curve above the
shutdown point is the
firm’s supply curve
ATC
AVC
PSD = Min AVC
qSD

Shut down if TR < VC
Pq < (AVC)(q)
P < AVC
quantity
How should a business react if…



Price rises?
Marginal costs rise?
Fixed costs rise?
$
MC
ATC
AVC
P1
MR1
q1
quantity
I have to
remember to
think at the
margin!
Long Run Equilibrium
• A = TR – Explicit Costs
• E = A - Implicit Costs
Firm =
Economy
7%
A= 9%
0%
E= 3%
7%
A= 6%
E= 0%
7%
A= 6%
E= 0%
7%
A= 6%
E= 0%
LRE: E = 0
if E > 0  entry occurs
if E < 0  exit occurs
Long Run Adjustment Process
$
$
MC
ATC
S1
S2
P2
MR2
LRS
P1
MR1
D2
D1
Q1
Q3
Quantity
Industry
q1 q2
quantity
Firm
At P1: each firm produces q1 and earns E = 0
Demand rises to D2: causes price to rise to P2
At P2: each firm produces q2 and earns E > 0
Since E > 0 , new firms will enter: supply shifts to S2
Price will fall back to P1 and E = 0
Long run supply curve
for a constant cost
industry is horizontal
The rutabaga market is perfectly competitive. Research is
published claiming that eating rutabagas leads to gaining
weight and so the demand for rutabagas permanently
decreases. The permanent decrease in demand results in a
a)
b)
c)
d)
lower price, economic losses by rutabaga
farmers, and entry into the market.
lower price, economic losses by rutabaga
farmers, and exit from the market.
higher price, economic profits for
rutabaga farmers, and entry into the
market.
higher price, economic losses by
rutabaga farmers, and exit from the
market.
0%
a)
1
2
3
4
5
0%
0%
b)
c)
0%
d)
Suppose that newspaper companies are now required to use
recycled paper, which is more expensive than new paper.
Which of the following is most likely to result if the
newspaper industry is highly competitive?
a)
b)
c)
d)
1
The firms’ costs will rise, resulting in positive
economic profit in the short run and, hence, the
industry supply curve will shift rightward in the
long run
The firms’ costs will rise, resulting in economic
losses in the short run and, hence, the industry
supply curve will shift rightward in the long run.
The firms’ costs will rise, resulting in economic
losses in the short run and, hence, the industry
supply curve will shift leftward in the long run.
The industry supply curve will shift leftward in
the short run, causing permanent long-run
economic losses
2
3
4
5
0%
a)
0%
0%
b)
c)
0%
d)
Ian’s fixed cost of mowing lawns is $250 and his marginal
cost is constant at $10 per lawn. If Ian mows 5 lawns in
one day, what is his average total cost?
$25
$50
$60
$300
a)
b)
c)
d)
1
2
3
4
5
0%
0%
0%
25
50
60
0%
300
A wheat farmer operating in the short run produces 100
bushels of wheat. Her average total cost per bushel is
$1.75, total revenue is $450, and (total) fixed costs are
equal to $100. Then
average fixed cost is equal to $1.50.
profit per bushel is equal to $2.75.
average variable cost is equal to $1.25.
economic profit is equal to $250.
a)
b)
c)
d)
0%
a)
1
2
3
4
5
0%
0%
0%
b)
c)
d)
Business people often speak about price elasticity
without actually using the term. Which of the following
quotations describes an elastic demand for a product?
1
2
3
4
5
0%
0%
0%
0%
d)
d)
c)
c)
b)
b)
a)
"A price cut won't help me. It won't increase
my sales; I'll just get less money for each unit
that I was selling before."
"I don't think a price cut will help my bottom
line any. Sure, I'll sell a bit more, but what I
may gain by selling more, I'll more than lose
because the price will be lower."
"My customers are real shoppers. Since I cut
my prices just a few cents below those my
competitors charge, customers have been
flocking to my store and sales are booming."
"The economic expansion has done wonders for
my sales. With more people back at work, my
sales are taking off, and I don't even have to
reduce my prices."
a)
A group of dairy farmers are trying to raise milk prices by 20%.
If the price elasticity of demand for is 0.75, and the price
elasticity of supply for milk is 0, then by how much should
farmers reduce their milk production to obtain the 20% increase?
2.7%
7.5%
15%
20%
a)
b)
c)
d)
%Q
E
 0.75
20%
1
2
3
4
5
0%
02
0.
7
0%
07
0.
5
0%
15
0.
0%
2
0.
For which of the following is the cross-price
elasticity of demand most likely a large positive
number?
french fries and onion rings
DVDs and milk
hockey pucks and hockey sticks
All of the above are correct,
because the cross-price elasticity
is always a positive number.
d)
a)
0%
1
2
3
4
5
0%
0%
0%
d)
c)
c)
b)
b)
a)